Merchants in a supply chain may be exposed to all kinds of contract risks. One example may be “inventory risk” which generally refers to the risk of a seller suffering a financial loss due to a decline in the value of its unsold inventory and/or an inability to dispose of the inventory. A typical source of inventory risks in supply contracts is buyer default.
For instance, a seller may enter into a supply contract with a buyer, wherein the buyer is committed to purchase the seller's inventory at an agreed-on price and over a predetermined timeframe. If the buyer defaults during the term of the contract, the seller will be saddled with those goods that have been specifically purchased or prepared for delivery to the buyer.
If the buyer default is a result of insolvency or bankruptcy, it is often difficult for the seller to make the buyer fulfill its contractual obligations. In bankruptcy, the defaulting buyer's executory contracts, such as supply contracts, are cancelable by a bankruptcy court. Under the Uniform Commercial Code (U.C.C.), the seller must now use commercially reasonable efforts to resell the undelivered goods (and any reclaimed goods) at the highest possible price. Sometimes, the seller simply cannot find another buyer to take the inventory balance. Even if there is another buyer, the actual resale or liquidation price may be substantially less than the contracted price. For example, inventory values of fashion goods or technological products often decrease quickly within a few months. As a result, the seller will suffer a financial loss known as “liquidation damages.”
While the seller may still have a claim of liquidation damages against the defaulting buyer who is in bankruptcy proceedings, such a claim is an unsecured debt which is subordinate to other senior debts which the buyer must satisfy first. In addition, the bankruptcy court may only recognize a portion of the seller's claim of liquidation damages. Thus, there is a significant risk that the seller cannot fully recover its claim of liquidation damages.
Similarly, if a seller goes bankrupt and defaults on a supply contract, the buyer may also suffer a significant loss. The buyer may have good reasons to enter into the supply contract, such as to ensure a steady supply of manufacturing input and/or to lock in an acceptable price. Upon seller default, the buyer may be forced to cover its needs by purchasing from other sources. However, there is no guarantee of a sufficient supply and the price may have gone up significantly. The buyer may have a claim against the defaulting seller for the cost of cover, which is the difference between the contracted price of the goods and the cost of the goods (replacement) actually purchased. The buyer's claim for the costs of cover would also be unsecured and subordinate to the senior debts the bankrupt seller might have.
A number of methods are currently available to a contracting party to hedge contract risks such as the risk of default by the other party or parties. For example, in the above-described scenario where the buyer might default due to bankruptcy, the seller may have a choice among such risk-hedging methods as factoring, trade insurance, and credit default swaps (CDS). However, none of these methods provides a satisfactory solution that is simple, flexible, and generally available at a reasonable cost. For example, factoring (or account receivable financing) typically has a minimum tenor of six months and may require three months of due diligence work just to set it up. In addition, the factoring approach may be either unavailable to or too expensive for high-yield or distressed companies.
While trade insurance policies are relatively inexpensive for some companies, they also tend to be unavailable to high-yield or distressed companies. A typical trade insurance policy lasts at least a year. The underwriting and review process for a trade insurance policy is quite long, and so is the claims process which may include a long waiting period. For customized trade insurance policies, the underwriting and claims processes may be even more cumbersome. Furthermore, instead of receiving a full coverage, the insured may be obligated to pay a 10-20% deductible or co-insurance.
CDS contracts are not much better than factoring or trade insurance. CDS contracts typically have minimum terms of 1, 3, or 5 years and are only available with respect to companies with sufficient liquidity. Furthermore, a CDS contract does not take into account specific contracts of a reference entity. In this respect, a contingent CDS (CCDS) contract is slightly better than a CDS contract as the former references the mark-to-market value of a hypothetical derivative transaction. However, a CCDS contract still does not accurately reflect the actual contract for which a contracting party is looking to hedge its risks. As a result, CDS or CCDS contracts almost invariably over-hedge or under-hedge risks for contracting parties.
JPMorgan Chase Bank has implemented a risk-hedging product known as “account receivables put,” whereby a seller may transfer to the bank a claim against a defaulting buyer for outstanding receivables. This product typically applies only to the seller's risk of losing account receivables (owed for goods/services already delivered to buyer). However, the account receivables put does not help the seller hedge other risks of damages that might result from buyer default.
In view of the foregoing, it may be understood that there are significant problems and shortcomings associated with current technologies of risk management.